Feb. 26 (Bloomberg) -- President Barack Obama is urging an end to government subsidies for student loan providers such as Sallie Mae and Citigroup Inc., with the government becoming the sole provider of federally backed college lending.

The government now offers direct loans through colleges, as well as guarantees for loans made by private lenders such as New York-based Citigroup and Reston, Virginia-based Sallie Mae, officially SLM Corp. Obama proposed the change in the budget he submitted to Congress today for the fiscal year beginning Oct. 1.

Education Secretary Arne Duncan said switching to government-funded loans would save more than $4 billion a year. “We want to actively invest that money in our students,” he told reporters today.

The proposal, which needs congressional approval, had an immediate impact on Wall Street. SLM fell $2.59 or 30.9 percent, to $5.80 at 4:15 p.m. in New York Stock Exchange composite trading.

“The market is shaken by this,” said David Long, an analyst with William Blair & Co. in Chicago. Federally backed loans are Sallie Mae’s “core business,” he said.

The Obama administration wants to use the savings from cutting student loan subsidies to increase spending on Pell grants, which help low-income families send children to college. The budget proposes spending an additional $116 billion over the next decade to increase the size of the awards and index them to inflation.

Subsidies Cut

In 2007, President George W. Bush signed legislation cutting subsidies to providers by $20.9 billion over five years.

Duncan said private companies would be asked to compete for government contracts to service the loans.

“The budget is a broad statement of purpose and does not address specifics or timing,” Sallie Mae spokesman Tom Joyce said. “In the months ahead, we will continue to work with the administration and Congress to implement the best solution for students, schools and taxpayers.”

“Confidence in the company is significantly diminished,” said Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pennsylvania. “The future has a larger cloud over it. Historically, students have had difficulty meeting their obligations and this just adds to the overall pressure on Sallie Mae.”

Floating-Rate Notes

Sallie Mae’s $850 million of floating-rate notes due in 2014 fell 6 cents to 58 cents on the dollar, their lowest price since November, at 10:48 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Credit-default swaps that protect against a default by Sallie Mae rose 11 percentage points to 25 percent upfront, according to prices from broker Phoenix Partners Group and CMA DataVision in New York. That is in addition to 5 percent a year and means it would cost $2.5 million initially and $500,000 annually to protect $10 million in debt for five years.

About 64 percent of federal student loans are made by private lenders, are subsidized and are guaranteed by the government, according to the House Education and Labor Committee. The remaining 36 percent are loans directly from the government to students, the method by which future loans would be made under Obama’s proposal. Colleges and universities now decide which programs they want to participate in.

‘Solid Plan’

Obama “has put forth a solid plan to make federal student loans more reliable, while saving taxpayers billions of dollars,” said Education Committee Chairman George Miller, a California Democrat. “In today’s economy, we must do everything we can to make sure that the federal student aid programs that students and families depend on are as reliable and efficient as possible.”

The Arlington, Virginia-based Consumer Bankers Association, whose members include Citigroup, criticized the proposal and called on Congress to reject it.

“We don’t believe that this proposal, which will increase the federal debt, is in the best interests of students, schools or taxpayers,” said Marcia Sullivan, director of government relations.

“We remain optimistic that Congress will continue to recognize the critical importance of private sector involvement in higher education financing for students and their families,” Citigroup spokesman Mark Rodgers said. “Healthy competition leads to choice, innovation and high standards of service.”

Obama’s proposed budget provides $46.7 billion for education, which he called one of the three major challenges the U.S. must address.

Education Is ‘Prerequisite’

“In a global economy where the most valuable skill you can sell is your knowledge, a good education is no longer just a pathway to opportunity. It is a prerequisite,” Obama told a joint session of Congress on Feb. 24.

Obama proposed a $500 million increase for education over the current fiscal year that ends Sept. 30. That wouldn’t include $81.1 billion in the $787 billion stimulus package Obama signed into law Feb. 17.

The budget calls for additional funding for early childhood education, new services for schools in economically depressed neighborhoods and more money to help schools where students’ educational performance is poor.

To contact the reporter on this story: Jonathan D. Salant in Washington at jsalant@bloomberg.net.

Last Updated: February 26, 2009 16:31 EST